Private-Equity Firms Forced to Evolve

Private equity once was among Wall Street’s glamour businesses. Buying businesses through the use of debt and reselling them at a steep profit helped turn Stephen Schwarzman and Henry Kravis—founders of Blackstone Group L.P. and KKR & Co., respectively—into billionaires.

The industry provided the basis for movies, such as “Wall Street,” and the best-selling book “Barbarians at the Gate,” which chronicled KKR’s purchase of RJR Nabisco in 1988. That saga, featuring a deal that loaded the company with debt, helped earn buyout bigwigs the “barbarian” sobriquet—as bestowed by the late Ted Forstmann, who died in November.

Today, the buyout business has become downright mundane, and by some measures, less lucrative.

Firms are doing fewer big deals in recent years and lately are running into difficulties selling companies they already own. With debt less available than before the financial crisis and prices for acquisitions up, returns on investments are down. As a result, private-equity bosses are focusing on midsize deals, growing existing businesses and expanding into real estate and other areas, rather than piling on debt for megadeals.

The shift is crucial for investors because endowments, pension plans and other institutions have hundreds of billions of dollars tied up with private-equity funds. They are counting on scoring outsize returns, in some cases to meet substantial obligations, for example to retired workers.

“It’s a new era,” says James Coulter, a co-founder of TPG Holdings, one of the industry’s largest companies. “Fixing a company, improving operations and driving growth are more important than financial engineering.”

Though deal makers were busy during the second quarter of 2011, the value of global buyouts is falling. It dropped 25% to $61.3 billion in the third quarter from the second, and declined further in the fourth quarter to $56.7 billion, according to Preqin, a research firm.

Sales and initial public offerings of companies owned by buyout firms are slowing at an even faster pace, Preqin says.

It also has become harder for some firms to raise debt—the linchpin of leveraged buyouts. Firms are using more cash, referred to as “equity” in private-equity parlance, for all but the largest acquisitions, and borrowing less.

Borrowed money, or leverage, made up 49% of buyouts last year, down from 57% in 2010, according to data-provider PitchBook. A $7.2 billion deal in November deal by KKR and a group of investors to buy energy company Samson Investment Co. involved more than $4 billion of equity. Less leverage can mean lower returns.

Investors in private-equity funds also have been affected. The industry has produced aggregate annual net returns through June 30, 2011, of between 5.3% and 10.9% for funds launched between 2004 and 2008, the most recent funds that have invested all or most of their money, according to Cambridge Associates, which tracks over 4,500 private equity firms.

While those beat the roughly 6% average annual gain for the Standard & Poor’s 500-index for that period, they are down from returns for funds started the previous five years, which range from 14.8% to 29.7%, Cambridge says. Buyout pros say returns during the early years of a fund often improve later as investments are sold.

Some industry participants worry that returns could drop further. The reason: Firms are flush with nearly $500 billion of investor money, according to Cambridge. Now, these investors are showing signs of overpaying as they try to put it all to work.

In 2011, private-equity firms paid acquisition prices averaging nearly nine times the earnings before interest, taxes, depreciation and amortization, or Ebitda, of target companies. That is up from seven times Ebitda earlier this decade and near the record 9.7 level in 2007, a year where many deals eventually proved disappointments.